Risks and Uncertainty in the Fed’s New Outlook

Summary

Thoughts on the Market: Risks and Uncertainty in the Fed’s New Outlook

Podcast Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Episode: Risks and Uncertainty in the Fed’s New Outlook
• Release Date: March 20, 2025

---

Introduction

In the March 20, 2025 episode of Thoughts on the Market, Morgan Stanley's Matthew Hornbach and Chief U.S. Economist Michael Gapen delve into the recent Federal Open Market Committee (FOMC) meeting. The discussion centers on the Federal Reserve's updated economic projections, the accompanying risks and uncertainties, and the implications for future monetary policy.

---

Federal Reserve's Updated Projections

Key Highlights:

• The Fed has aligned its projections more closely with Morgan Stanley's outlook, indicating a potential stagflation scenario with slower economic growth and persistently high inflation.
• There is significant policy uncertainty highlighted in the Fed’s updated projections.

Notable Quotes:

• Michael Gapen (00:26): “The Fed’s forecasts actually now look a lot like our outlook for the US Economy. So they revised down their expectation of growth, they revised up their expectation for inflation.”

Discussion: Michael Gapen emphasizes that the Fed's downgrading of growth expectations and upward revision of inflation forecasts align with Morgan Stanley's own economic outlook. This alignment suggests a shared view of a challenging economic environment characterized by sluggish growth and entrenched inflation rates.

---

Assessing Policy Uncertainty and Risks

Key Highlights:

• The Fed underscored high uncertainty regarding both inflation and economic growth.
• There are competing risks related to the Fed's dual mandate: inflation risks are skewed to the upside, while growth risks tilt to the downside.

Notable Quotes:

• Michael Gapen (01:45): “The Fed highlighted high policy uncertainty. They wrote down a forecast, but I'm not all that convinced that they have a lot of confidence in how things will evolve.”
• Gapen continues (02:15): “You have kind of competing risks here around the Fed’s dual mandate. They’ve got upside risk to inflation, downside risk to growth.”

Discussion: Gapen points out that the Fed's communication reveals a lack of confidence in the economic outlook, emphasizing the high uncertainty surrounding both inflation and growth. This dual uncertainty poses a complex challenge for the Fed's policy decisions, balancing inflation control with supporting economic growth.

---

Federal Reserve's Policy Response

Key Highlights:

• Fed Chair Jerome Powell suggests a cautious approach, potentially holding rates steady or considering cuts if economic conditions deteriorate.
• The Fed may overlook short-term inflationary pressures from tariffs but be prepared to ease policy if the economy weakens.

Notable Quotes:

• Michael Gapen (01:56): “Powell said we're either going to be on hold or we're going to be cutting rates. And generally I think that's the right thing.”

Discussion: Matthew Hornbach inquires about Powell’s stance on appropriate policy actions given the current uncertainties. Gapen interprets Powell's comments as signaling a possible pause in rate hikes or even rate cuts, depending on how economic indicators evolve. This cautious stance reflects the Fed's attempt to navigate the delicate balance between inflation control and economic support.

---

Market Expectations vs. Fed Projections

Key Highlights:

• The market currently prices in more rate cuts for 2026 than for 2025, partially aligning with Morgan Stanley's outlook.
• There exists a discrepancy between the market's average pricing of outcomes and Morgan Stanley's expectations.

Notable Quotes:

• Matthew Hornbach (03:50): “The market hasn't fully priced in the risk premia that the Fed might need to cut rates more aggressively.”

Discussion: Hornbach and Gapen discuss the divergence between market expectations and Morgan Stanley's projections. While the market anticipates rate cuts extending into 2026, Morgan Stanley believes cuts may be more delayed and heavily data-dependent. This difference underscores the complexity of forecasting in an environment riddled with uncertainties.

---

Impact on Equity Markets

Key Highlights:

• A significant decline in equity markets could influence Fed policy by affecting household wealth and consumer behavior.
• The Fed and Morgan Stanley are cautious about equity market volatility and its potential spillover effects on the broader economy.

Notable Quotes:

• Michael Gapen (05:22): “We would need about a 30% decline in equity markets before that spillover risk gets very elevated.”

Discussion: The conversation touches on the potential ramifications of a major equity market downturn. Gapen suggests that while a 10% decline is relatively routine, a more substantial 30% drop could pose significant risks to economic stability by impacting consumer wealth and spending. This perspective highlights the interconnectedness of financial markets and economic policy.

---

Looking Forward: Focus on U.S. Trade Policy

Key Highlights:

• Investors are keenly watching for developments in U.S. trade policy, particularly the Trump administration's plan for reciprocal tariffs slated for April 2nd.
• Anticipation of policy announcements and their implications for the economy over the next several years is a central concern.

Notable Quotes:

• Matthew Hornbach (06:52): “Clients are very focused on April 2nd. There's a crescendo in concern, perhaps over what will come of US Trade policy for the balance of this year and really for the balance of the next three and a half years.”

Discussion: The impending announcement of reciprocal tariffs by the Trump administration is a focal point for investors. The uncertainty surrounding which tariffs will be implemented and their long-term impact on trade relations and economic growth is generating heightened attention and concern among market participants.

---

Conclusion

The episode effectively captures the current economic landscape marked by high uncertainty and competing risks related to inflation and growth. Morgan Stanley's Matthew Hornbach and Michael Gapen provide insightful analysis into the Fed's cautious approach, the disparity between market expectations and their projections, and the potential impact of U.S. trade policies on future economic conditions. As the Fed navigates these complex dynamics, investors remain attentive to policy developments and market indicators that will shape the trajectory of the U.S. economy in the coming years.

---

Notable Quotes Summary:

• Michael Gapen (00:26): Highlights alignment between Fed projections and Morgan Stanley’s outlook.
• Gapen (01:45): Emphasizes high policy uncertainty and competing risks.
• Gapen (01:56): Discusses potential Fed policy actions of holding or cutting rates.
• Matthew Hornbach (03:50): Notes market’s pricing in additional rate cuts beyond Morgan Stanley’s expectations.
• Gapen (05:22): States that a 30% equity decline would significantly elevate spillover risks.
• Hornbach (06:52): Points to investor focus on impending U.S. trade policy decisions.

---

This comprehensive summary encapsulates the key discussions and insights from the episode, providing valuable context and analysis for those seeking to understand the current market dynamics and Federal Reserve outlook.

Transcript

[Matthew Hornbach]

Welcome to Thoughts on the Market. I'm Matthew Hornbach, global head of MacroStrategy.

[Michael Gapen]

And I'm Michael Gapen, Morgan Stanley's chief U.S. economist.

[Matthew Hornbach]

Today we're talking about the March Federal Open Market Committee meeting and the path for rates from here. It's Thursday, March 20th at 10:00am in New York. Mike, the Fed released a new set of projections yesterday. What do these say and what did you learn from them?

[Michael Gapen]

Yeah, Matt. Well, the Fed's forecasts actually now look a lot like our outlook for the US Economy. So they revised down their expectation of growth, they revised up their expectation for inflation. So it has a bit of a stagflation, slower growth, stickier inflation outlook, which is very much what we were thinking coming into this year. The Fed also, though, highlighted high policy uncertainty. The they wrote down a forecast, but I'm not all that convinced that they have a lot of confidence in how things will evolve. So I think for me, really the bigger story were their updated perceptions about uncertainty and risks to the outlook. So in December, if you remember, they told us virtually everybody on the committee said uncertainty around inflation is high and risk to inflation to the upside. They complimented that this week with the fact that uncertainty around growth in the labor market is high, but risk to growth is to the downside, the unemployment rate, to the upside. So you have kind of competing risks here around the Fed's dual mandate. They've got upside, risk to inflation, downside, risk to growth. To me, that's kind of the really important message. It's hard to have confidence in a forecast right now, but I think that risk assessment is really interesting with that in mind.

[Matthew Hornbach]

And given all of the policy uncertainty that the Fed mentioned, what did Powell say about how the Fed should react? In other words, what is appropriate policy at this stage?

[Michael Gapen]

Right. Yeah, it's tricky, right? So on one side of your mandate, you think risk to inflation are squarely to the upside and growth in labor markets to the downside. So what do you do? And I think Powell said, I think that the logical answer, which is, well, right now you do nothing and you wait. But then I think what Powell said is how we think this plays out is tariffs may boost inflation in the short run, which we're going to try to ignore. And if the economy does weaken and the labor market softens, we'll ease policy in order to support activity. Right. So there might be, say, symmetric risks around their dual mandate, but there's asymmetry in the policy outlook. He said we're either going to be on hold or or we're going to be cutting rates. And generally I think that's the right thing.

[Matthew Hornbach]

So Mike, what I heard from you was that the Fed was going to look through inflation in the near term and then eventually cut. I mean, do you think they can do that?

[Michael Gapen]

Yeah, I think, Matt, that's a great question. My answer to that is I think it's easier said than done. We agree that the next move from the Fed is going to be a cut, but we think that cut comes much later. Later. This is a very data dependent Fed. So I think in the moment if tariffs boost inflation now and weaken activity later, it's easy to say I'm going to look through that and cut. But in practice I think it's hard. So Matt, actually at this point though, I think I would actually kind of ask you the same question, but in a different way. Right. We doubt the Fed may be able to do this, but the market priced in more rate cuts this year than we think is likely. How would you explain the market pricing and how far away from my expectation do you think it could run?

[Matthew Hornbach]

What's really interesting about how the market has priced the recent events is it's actually pricing more in line with the spirit of your view, in the sense that the market has priced more rate cuts in 2026 than it's pricing in 2025. So in spirit, the market is very much with you. But as we like to say, the market price is an average of all possible outcomes. And if one of the outcomes is the Fed does nothing for the foreseeable future and the other outcome is the Fed cuts aggressively this year, then the market price has to reflect some degree of additional easing in 2025 that wouldn't necessarily be aligned with a rational baseline for Fed policy. So the market in some ways is reflecting the idea that you're proposing in your forecast, but it's also reflecting the idea that it's a market and that it has to be priced for some amount of risk premia that the Fed is ultimately forced to cut rates more. And in fact, if I can ask you a question relating to that, Mike. The equity market at one point last week had fallen about 10% from the highs. Number one, is there a percentage drawdown that gets the Fed's attention? How does the Fed think about the equity market in an environment like this?

[Michael Gapen]

I think the equity market in my view, and I think the view of the Fed is what I'll call a key spillover channel. Trade and manufacturing are relatively small shares. So if we pursue restrictive trade policies, growth should slow, inflation may be firm. That's the Fed's essential baseline. It's ours. The risk here, though, is that somewhere in there you get a destabilizing period. Equity markets fall, upper income consumers take a step back and you have a much broader downturn at that point. So you ask a great question. How far do equity markets have to fall? Well, we get 10% declines in equity markets on average about once a year. So it's not that the theory would say households have to view that decline in wealth as permanent. Right. So it has to be a fairly substantial decline given how far wealth has risen. We're over 51 trillion now in an increase in net wealth since COVID I think that decline has to be large. I would pencil in something, probably need about a 30% decline in equity markets before maybe that spillover risk gets very elevated. So, Matt, if I can turn back, because I think we're in general agreement here on what we heard yesterday, but what I'd like to do in terms of looking forward so aside from the usual communications coming from the Fed after the blackout period following the meeting, what do you think investors will be focusing on over the next month?

[Matthew Hornbach]

My sense is that there is already an unusual amount of focus on April 2nd. That is the day when the Trump administration is supposed to unveil their plan for reciprocal tariffs. It's unclear what tariffs will be implemented on April 2, what tariffs will be saved for a negotiating process thereafter. So clients are very focused on April 2nd. I also suspect that at some various periods between now and then, we are likely to receive previews in the form of various communications coming from the Trump administration on the types of policies that we may end up seeing delivered on April 2nd. And so I suspect that between now and then there will be a crescendo in concern, perhaps over what will come of US Trade policy for the balance of this year and really for the balance of the next three and a half years. So with that, Michael, thanks for taking the time to talk.

[Michael Gapen]

Great speaking with you, Matt, and thanks for listening.

[Matthew Hornbach]

If you enjoy thoughts on the market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.

[C]

The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for.